The most fundamental principle in finance fits in one sentence: you can only expect a higher return by accepting a higher risk. Understanding this pair is understanding 80% of investing.
What is risk, concretely?
Risk is not only “losing money”. In finance it is often measured by volatility: the amplitude of price swings. An asset whose price swings sharply is risky, even if it rises over the long run, because it can fall abruptly at the worst moment.
Return is paid for in uncertainty
Cash (a savings account) pays little but does not move. Equities have historically paid the most over the long run (around 7% real per year for a broad index), but can lose 30% to 50% in a crash. Bonds sit between the two and offer a compromise.
The risk people forget
Taking no risk is a risk too: holding everything in cash means losing purchasing power to inflation, slowly but surely.
An illustration
Over one year, a share can return +40% or −30%. Over 20 years, the probability of a loss on a diversified equity index becomes historically very low. Time turns short-term risk into long-term performance.
À retenir
- ✓Expected return and risk go together: be wary of any promise of “high return with no risk”.
- ✓Volatility measures the size of the swings, not the quality of the company.
- ✓Your time horizon is your best ally for taming risk.